The cost of borrowing in dollars overnight surged the most on record after the U.S. Congress rejected a $700 billion bank rescue plan, heightening concern more institutions will fail.

The London interbank offered rate, or Libor, that banks charge each other for such loans climbed 431 basis points to an all-time high of 6.88 percent today, the British Bankers' Association said. The euro interbank offered rate, or Euribor, for one-month loans climbed to record 5.05 percent, the European Banking Federation said. The Libor-OIS spread, a gauge of the scarcity of cash, advanced to a record. Rates in Asia also rose.

``The money markets have completely broken down, with no trading taking place at all,'' said Christoph Rieger, a fixed- income strategist at Dresdner Kleinwort in Frankfurt. ``There is no market any more. Central banks are the only providers of cash to the market, no-one else is lending.''

This is far more serious than most people understand or even realise. When banks will not lend to each other—because nobody knows who’s holding the toxic waste—not only does consumer and commercial credit become strictly rationed, banks may have real difficulty in maintaining their statutory ratios of lending to assets.

If the asset side of the equation drops too far the bank has only a few options, mainly: a) short-term borrowing from other banks—which is now mostly seized up, b) selling assets to raise cash—but they have to find a buyer, c) injections of new investor capital—issuing more shares, or d) reduce outstanding lending—cutting credit card limits, calling in loans, and the like.

If you read your mortgage closely, it is likely you’ll find a clause giving the bank the right to call that mortgage on no more than 90 days notice. The nasty part is that when that happens the tendency will be to call in loans from good borrowers, not bad ones, because good borrowers may actually be able to come up with the money if they liquidate a lot of other assets.

A credit freeze is profoundly deflationary, especially for financial assets. That’s what happened in Japan, but they wouldn’t let the failures fail, so it has dragged on there for almost 20 years.

Even government intervention at this point will only improve things somewhat, and only for awhile. I wish there were better news, but economic history is quite clear that deflating credit bubbles vary only in the details and the duration.

This is why the “toxic waste” needs to be liquidated at market prices, rather than propped up by printing $700 billion simoleons. It would also help if we would reduce the horrendous rate of government consumption of private wealth. But of course, we’re all socialists now.